Utilities have been at the top of active investors’ buy lists the past two months, along with emerging markets. Put those two ideas together, and you get a Brazilian utility that I’ve been recommending for the past two months: CPFL Energia (NYSE: CPL).
The company is based in the seventh largest metropolitan area in the world, Sao Paulo, and provides exposure to one of the world’s fastest growing markets. It also pays a 6.4% annual dividend, which as you know has been much prized of late.
CPFL, with $6.2 billion in annual sales and an $11.5 billion market cap, is about twice the size of most mid-market U.S. utilities. It serves 6.6 million residential, industrial, and commercial customers throughout four major industrial states in Southern Brazil.
CPFL has electrocuted its local and emerging market competition as a stock since 2005. It’s up 432% while the Brazilian stock exchange, Bovespa is up 159%. Meanwhile, utilities in the United States are up 30%, while the S&P 500 is down. That’s some serious relative strength.
The Brazilian utility market is highly fragmented, which makes many small companies attractive takeover targets. CPFL recently acquired CMS Energy Brazil to gain greater access to the densely populated industrial center of Sao Paulo. CPFL’s size and healthy balance sheet should enable more value-enhancing acquisitions.
The Brazilian utility has a natural monopoly in most of its operating area. Its cash flow is consistent and predictable as three fourths of operating income is derived from regulated electricity sales. The remaining 25% comes from consumers who choose between CPFL and competitors based on price.
High fixed costs should permit CPFL to add new customers at very low marginal costs. Morningstar analysts expect profit margins and returns on capital to increase as this revenue falls to the bottom line.
CPFL will be a key beneficiary of Brazilian growth, as the largest Latin American country is largely insulated from sluggish activity of the northern hemisphere. Brazil has a growing domestic consumer base, geographically diverse trading partners, and a stable financial system, which strengthened after it went through its own financial crisis a decade ago.
In the first quarter of 2010, Brazil grew at its fastest pace in fifteen years, 9.0%. Investment grew 26% and private sector credit grew 17% compared to the same period last year. Economists expect 6.9% annual GDP growth going forward, up more than 1 percentage point from the previous consensus forecast.
Long-term trends suggest favorable conditions for CPFL. Brazilian per capita energy consumption is only 2,500 kilo-watt hours (kWh) per person compared to 13,000 kWh in the United States. ANEEL, the Brazilian electricity regulator, expects electricity demand to grow 4.5% annually through 2014.
About 85% of Brazil’s electricity comes from hydroelectricity, not fossil fuels. This isolates domestic utilities from commodity price fluctuations but exposes the grid to blackouts during droughts. CPFL is constructing biomass plants and wind farms to diversify its generation base. Future coal and nuclear plants are also a possibility.
Chief exec Wilson Ferreira Jr. has served in his position since 2002 and formerly ran several CPFL subsidiaries. Analysts expect the company to earn $5.80 in 2011, which prices the stock at 12.5x forward earnings. My model expects the Brazilian utility to earn $6.00 in 2011 and continue to increase free cash flow. A 14 P/E coupled with my estimate suggests an $84 price target, or 16% higher than the current price. This valuation would leave CPFL with a 5.4% yield, more than sufficient to attract income-oriented investors. It’s a buy on dips.
For more ideas like this, please check out Jon Markman’s daily trading advisory service Trader’s Advantage, or my long-term investment letter, Strategic Advantage.
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